Do you remember the crash of 1999?

Chris Robinson, an actor who appeared on “General Hospital”, certainly does. He invested $100,000 hoping to fund his kids’ college education and lost everything. He was left with nothing; well, apart from 20,000 stuffed toys in his garage. 1999 was the year when the barmy Beanie Baby bubble burst*.

History of bubbles

That was just one more in a long history of economic bubbles. An early bubble was the famous Dutch tulip bulb mania in the 1630s, when an inefficient market allowed the price of tulip bulbs to soar because garden centers hadn’t been invented yet. And if the Brits had been sniggering at the behaviour of those wacky Dutch, they got their comeuppance a hundred or so years later when they piled into the South Sea Company. At the time, many companies jumped on the bandwagon and set up during the South Sea bubble; one such company sold itself as, “carrying on an undertaking of great advantage; but nobody to know what it is.” ­ which must be one of the most cynical, or honest, company mission statements ever.

Since then the bubbles have kept coming, and popping. We’ve had bubbles in stocks, bonds, real estate, canals, railways, commodities, derivatives, almost anything that has a price.

However, despite bubbles being such a pervasive part of our economic lives there is remarkably little understanding of them.

Anatomy of bubbles

A simple definition of a bubble might be: an asset trading at a price far in excess of its intrinsic value. Sounds reasonable. But intrinsic value isn’t always easy to calculate, especially in today’s world of digital assets. Alternatively, jaundiced traders might define a bubble as merely an increasing asset price that you’re not invested in.

What causes bubbles?

The background conditions may include easy credit, loose regulations, and cross border investment, but what causes an actual bubble? There is no general agreement on this.

Some hold that they start with an economic or technological event that justifies some increase in asset price, but then emotion takes over. This theory would probably have been supported by Sir Isaac Newton who having invested in the South Sea Company famously said, “I can calculate the movement of the stars, but not the madness of men”. Years later John Maynard Keynes was of a similar mind when he commented, “Markets can remain irrational longer than you can remain solvent”.

So, bubbles are the result of irrationality?

Not necessarily, say some academics: bubbles may be argued to be perfectly rational, where investors at every point are fully compensated for the possibility that the bubble might collapse by higher returns. Recently, other academics have argued that bubbles are sociologically driven.

Can we control bubbles?

In theory, central banks can try to curb high levels of speculation through monetary policy actions that might include raising interest rates (sometimes referred to as taking the punch bowl away just as the party is getting good). Fine in theory, but difficult to finesse in practice ­ assuming the will is even there.

Even if we can control bubbles, should we?

The aftermath of some bubbles can have a very negative effect on the wider economy, for example the fall-out from the credit crunch in 2008. But, some bubbles, while they lose money for investors, leave behind an infrastructure that benefits wider society. For example, canals, railways, and the internet needed excess speculation to raise sufficient funds to build expensive infrastructure, that later generations benefited from.

Current and future bubbles

Today, thanks to quantitative easing by central banks, we have what some call the Everything Bubble, which includes stocks, real estate, fine art, corporate credit, auto and student loans. Discount brokerages in the U.S. have reported a surge in trading volumes, with millennial investors particularly active in cryptocurrency and cannabis investments[2] (the latter giving new relevance to the term joint stock companies).

So, currently, we’re likely to be more interested in which bubbles will burst first, than looking for new bubbles. But thinking further ahead what bubbles might we see in the future?

As The Economist recently pointed out, digital assets with no income streams are very hard to value. So, an obvious place to look for future bubbles will be in the universe of digital assets. For example, if online identities ever become tradable, they could be bubbleable. If the clever people at investment banks manage to securitise access to air and water, then air bubbles and water bubbles would be feasible, and likely.

At the beginning of this year California became the latest U.S. state to legalize recreational marijuana. According to Forbes, cannabis-related businesses constitute one of the fastest growing industries in the US, with the medical marijuana market alone expected to grow to $13 billion by 2020. There are still regulatory hurdles to overcome in the U.S., but as these are cleared away expect pot-heads, and prices, to get high and cannabis investments will add a new meaning to the term joint stock companies.

The FT recently reported that there are now over three million stock indices, which is 70 times as many quoted stocks in the world ­what might be called a bubble in bubble barometers[3]. In this rush to indexify everything, surely it is only a matter of time before there’s a dedicated Bubble Index, that measures the aggregate bubbliness of global assets. At which point, ETFs, options and futures can appear linked to that index, which could lead to a bubbles in bubbles ­a bubble bubble.

How to spot a bubble

Will we be able to predict these bubbles?

Yes, says Robert Shiller; no, says Eugene Fama. Shiller and Fama were co-winners of the Nobel prize for economics in 2013; suggesting, again, that economics is less a science and more an art ­ an art drawn in thick crayons by an 8-year old. Some traders would say, don’t bother trying to predict bubbles, just ride the trend.

If we did want to try to spot bubbles, we might start by observing that they tend to occur during long periods of low interest rates, leading to increased debt levels and investors chasing income. High asset prices are often justified by the four most dangerous words in investment: it’s different this time. And polite dinner conversations turn to, say, the relative merits of Bitcoin and Ripple. So, these are some warning signs if you want to protect your investment portfolio from bubbles. And avoid any asset called Old Face Teddy.

The Great Beanie Baby Bubble: Mass Delusion and the Dark Side of Cute”, Zac Bissonnette

An edited version of the above first appeared in Spectator Money.

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